Thursday, 27 September 2007

A reader asks: ''Interested in any comments you might have on XBB & XSB bond ETF's. Performance has been poor this year even with dividends.''

You are right, the performance of both has not been very good, barely keeping pace with inflation over the past year at around two and a half percent total return (for details see the Fixed Income list at iShares.ca product page). That's the reflection of the usual pattern - when interest rates rise, as they have, bond prices go down and so the market value of XBB and XSB suffer. If interest rates remain stable, the yield of around 4 to 5 % will re-establish itself as the bond return. Though the returns haven't been good, I'd still consider them a good long term investment as part of a diversified portfolio with equities. I don't actually own any myself since I have been buying individual bonds, which have also gone down in market value.

If equities are having their day now, bonds will again have theirs sometime. Compared to bond mutual funds, the iSharesXBB and XSB have lower MERs so from that perspective they give you more. And they are passive index trackers, rather than active managers, which most bond mutual funds are. That's another advantage of XBB and XSB.

Meantime, you can keep receiving the cash distributions (not technically dividends but interest income when it comes to tax reporting). If you treat them like I do as part of a portfolio, come rebalancing time if they are still down in value and less than their target percentage of your portfolio, I'd sell some equities and buy more XBB and XSB to get back up to the target. I call it the autopilot ''sell high, buy low'' strategy.

One issue I have with buying bond funds (particularly the ETFs, but also the mutuals), is that they are continuously 'rolling' their bonds to maintain their target duration/maturity. As a result, they don't hold bonds to maturity and have to lock in gains/losses when they trade bonds that are leaving their maturity period to buy other bonds that will fit. Trade timing can be a big hazard for bond owners.

I've bought individual bonds on a corporate basis, and I plan on buying them for myself when I get closer to retirement. You often get killed on the spread that your broker quotes you, and pricing isn't that transparent. At the end of the day, you need to forget about how you're getting fleeced on the transaction and determine whether the quoted yield is sufficient for you. As long as you buy a good quality bond (ie. low default risk), then you're pretty much guaranteed to get that return.

FourP, Thanks so much for this question. Though the direct answer is likely that it likely takes $50k in bonds or more to be worthwhile to create a ladder (10 bonds times $5k min per bond), it got me thinking and looking around again ... to discover real return bonds, which seem to be a new potential asset class, non-correlated with either straight bonds or equities. Very handy for reducing portfolio variability and enhancing returns. Still doing the investigation and will write up soon.